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macroeconomics fifth edition N. Gregory Mankiw PowerPoint Slides by Ron Cronovich macro 2004 Worth Publishers, all rights reserved CHAPTER FOUR Money and Inflation Slide 2 CHAPTER 4 Money and Inflation slide 1 Money: definition Money is the stock of assets that can be readily used to make transactions. Slide 3 CHAPTER 4 Money and Inflation slide 2 Money: functions 1. medium of exchange we use it to buy stuff 2. store of value transfers purchasing power from the present to the future 3. unit of account the common unit by which everyone measures prices and values Slide 4 CHAPTER 4 Money and Inflation slide 3 Money: types 1. fiat money has no intrinsic value example: the paper currency we use 2. commodity money has intrinsic value examples: gold coins, cigarettes in P.O.W. camps, stone wheels up to 12 feet (3.6 meters) in diameter (Yap) Slide 5 CHAPTER 4 Money and Inflation slide 4 Money Supply Government control over supply of money is called monetary policy. In Ukraine, National Bank of Ukraine carries out monetary policyNational Bank of Ukraine The primary way of controlling the supply of money is through the open-market operations: Purchase of government bonds from public increase money supply Sale of government bonds to public reduce money supply Slide 6 CHAPTER 4 Money and Inflation slide 5 Measurement of Money Slide 7 CHAPTER 4 Money and Inflation slide 6 The Quantity Theory of Money A simple theory linking the inflation rate to the growth rate of the money supply. Begins with a concept calledvelocity Slide 8 CHAPTER 4 Money and Inflation slide 7 Velocity basic concept: the rate at which money circulates definition: the number of times the average dollar bill changes hands in a given time period example: In 2003, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2003 So, velocity = 5 Slide 9 CHAPTER 4 Money and Inflation slide 8 Velocity, cont. This suggests the following definition: where V = velocity T = value of all transactions M = money supply Slide 10 CHAPTER 4 Money and Inflation slide 9 Velocity, cont. Use nominal GDP as a proxy for total transactions. Then, where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) Slide 11 CHAPTER 4 Money and Inflation slide 10 The quantity equation The quantity equation M V = P Y follows from the preceding definition of velocity. It is an identity: it holds by definition of the variables. Slide 12 CHAPTER 4 Money and Inflation slide 11 Money demand and the quantity equation M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P ) d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous) Slide 13 CHAPTER 4 Money and Inflation slide 12 Money demand and the quantity equation money demand: (M/P ) d = k Y quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low). Slide 14 CHAPTER 4 Money and Inflation slide 13 back to the Quantity Theory of Money starts with quantity equation assumes V is constant & exogenous: With this assumption, the quantity equation can be written as Slide 15 CHAPTER 4 Money and Inflation slide 14 The Quantity Theory of Money, cont. How the price level is determined: With V constant, the money supply determines nominal GDP (P Y ) Real GDP is determined by the economys supplies of K and L and the production function (chap 3) The price level is P = (nominal GDP)/(real GDP) Slide 16 CHAPTER 4 Money and Inflation slide 15 The Quantity Theory of Money, cont. The quantity equation in growth rates: Slide 17 CHAPTER 4 Money and Inflation slide 16 The Quantity Theory of Money, cont. Let (Greek letter pi) denote the inflation rate: The result from the preceding slide was: Solve this result for to get Slide 18 CHAPTER 4 Money and Inflation slide 17 The Quantity Theory of Money, cont. Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. Slide 19 CHAPTER 4 Money and Inflation slide 18 The Quantity Theory of Money, cont. Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Slide 20 CHAPTER 4 Money and Inflation slide 19 International data on inflation and money growth Slide 21 CHAPTER 4 Money and Inflation slide 20 U.S. data on inflation and money growth Slide 22 CHAPTER 4 Money and Inflation slide 21 U.S. Inflation & Money Growth, 1960-2003 Slide 23 CHAPTER 4 Money and Inflation slide 22 Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i Slide 24 CHAPTER 4 Money and Inflation slide 23 The Fisher Effect The Fisher equation: i = r + S = I determines r. Hence, an increase in causes an equal increase in i. This one-for-one relationship is called the Fisher effect. Slide 25 CHAPTER 4 Money and Inflation slide 24 U.S. inflation and nominal interest rates, since 1954 Nominal interest rate Inflation rate Slide 26 CHAPTER 4 Money and Inflation slide 25 Inflation and nominal interest rates across countries Slide 27 CHAPTER 4 Money and Inflation slide 26 Ex ante and ex post inflation Ex ante variable: e = expected inflation rate Ex post variable: = actual inflation rate (not known until after it has occurred) When lender and borrower agree on a nominal interest rate, they do not know what the rate of inflation is going to be, hence Modified Fisher Effect: i=r+ e Slide 28 CHAPTER 4 Money and Inflation slide 27 Nominal interest rate and the demand for money i is opportunity cost of holding money: you can deposit it in a savings account which earn the nominal interest rate rather then keep it under the mattress Slide 29 CHAPTER 4 Money and Inflation slide 28 Equilibrium The supply of real money balances Real money demand Slide 30 CHAPTER 4 Money and Inflation slide 29 What determines what variablehow determined (in the long run) Mexogenous (the Central Bank) radjusts to make S = I Y P adjusts to make Slide 31 CHAPTER 4 Money and Inflation slide 30 How P responds to M For given values of r, Y, and e, a change in M causes P to change by the same percentage --- just like in the Quantity Theory of Money. Slide 32 CHAPTER 4 Money and Inflation slide 31 How P responds to e For given values of r, Y, and M, Slide 33 CHAPTER 4 Money and Inflation slide 32 Discussion Question Why is inflation bad? Slide 34 CHAPTER 4 Money and Inflation slide 33 A common misperception Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. Consider the data Slide 35 CHAPTER 4 Money and Inflation slide 34 Average hourly earnings & the CPI Hourly earnings in 2004 dollars Consumer Price Index Average hourly earnings (nominal) Slide 36 CHAPTER 4 Money and Inflation slide 35 The classical view of inflation The classical view: A change in the price level is merely a change in the units of measurement. So why, then, is inflation a social problem? Slide 37 CHAPTER 4 Money and Inflation slide 36 Homework Assignment Read Section 4-6 of the textbook. Answer the following questions: Do economists and other people differ in their view on costs of inflation? What are the costs of expected inflation? What are the costs of unexpected inflation? Is there anything good about inflation anyway? Slide 38 The Classical Dichotomy Real variables are measured in physical units: quantities and relative prices, e.g. quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today Nominal variables: measured in money units, e.g. nominal wage: dollars per hour of work nominal interest rate: dollars earned in future by lending one dollar today the price level: the amount of dollars needed to buy a representative basket of goods slide 37 Slide 39 CHAPTER 4 Money and Inflation slide 38 The Classical Dichotomy Classical Dichotomy : the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. Neutrality of Money : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run. Slide 40 CHAPTER 4 Money and Inflation slide 39 Chapter summary 1. Money the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls money supply. 2. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate determines the inflation rate. Slide 41 CHAPTER 4 Money and Inflation slide 40 Chapter summary 3. Nominal interest rate equals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. is the opp. cost of holding money 4. Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate; if so, then changes in expected inflation affect the current price level. Slide 42 CHAPTER 4 Money and Inflation slide 41 Chapter summary 5. Classical dichotomy In classical theory, money is neutral--does not affect real variables. So, we can study how real variables are determined w/o reference to nominal ones. Then, eqm in money market determines price level and